We present the case that Big 3 PBMs — CVS Health, Express Scripts, and OptumRx — and the Sopranos are both gatekeepers who limit access to otherwise competitive markets. In return, PBMs and the Sopranos take an outsized slice of the super-competitive profits. The analogy is presented in the diagram below:
The Sopranos Business Model
In the pilot episode of the HBO hit series The Sopranos, Tony Soprano complained to his therapist Dr. Melfi about the stresses of being a “waste management consultant.”
Tony’s “consulting practice” consisted of managing the competing interests of various sanitation companies wishing to win lucrative garbage collection contracts put out to bid by suburban New Jersey municipalities.
Tony guaranteed garbage collection companies exclusivity in bidding on any given municipal garbage contract. This exclusivity was insured via dispatching his nephew Christopher to persuade the unfavored that bidding on a given contract would be dangerous to their health.
In return for exclusivity, Tony and his crew received a large slice of the super-competitive profits earned by the favored bidder.
The Sopranos provide no real value added here. Their operation was designed to transfer value, a.k.a. theft, from down-steam consumers to sanitation companies while taking an outsized slice of the transfer.
The competition-limiting gatekeeper role can be stressful. Hence the need for Tony to seek out Dr. Melfi. Tensions can break out among the sell-side sanitation companies with cries of favoritism and “unfairness” in the Sopranos cut of the overall surplus. Instead of a psychiatrist, maybe Tony should have sought out the advice of game and bargaining theorists with knowledge of Nash equilibriums?
Being the wisest guy in the Soprano crew, Tony was careful not to play favorites and cognizant of being too greedy. That way no sanitation company was motivated to break ranks and seek out other gatekeeping crews like the DiMeo’s or the Lupertazzi’s.
Note that the few players on both the sell-side — sanitation companies — and the buy-side — Mafia crews — mattered here. Had there been 10+ sell-side sanitation companies, there would have been no way Tony’s nephew Christopher could have the time to enforce limited competition for bids. Competitive bidding would breakout eliminating super-competitive profits.
Also, had there been 10+ Mafia crews competing with the Tony’s crew, he would not have been able to demand and get the outsized kickbacks that he got.
In economic terms, a market characterized by a few buyers and a few sellers is known as a bilateral oligopoly. Prices are negotiable as the gain or loss of single trading partner has a material effect.
Note that business model matters here. Tony could have been a legitimate fee-for-service waste management consultant helping NJ municipalities structure bid contracts and perform due diligence on sanitation companies. Under this business model, Tony’s interests align with his buy-side clients’ interests in getting most cost-effective service. There would have been no “theft” from downstream consumers.
The Pharmacy Benefit Manager Business Model
The management of the prescription (Rx) drug benefit portion of health care plans has become the domain of contracted specialists called pharmacy benefit managers (PBMs).
The three largest, independent PBMs — Express Scripts, CVS Health, and Optum Rx, (known as “The Big 3”) control 73% of the total Rx claims processed the United State in 2015.
PBMs provide a bundle of managed care services designed to provide a cost-effective Rx drug benefit to plan sponsors and their members.
Since the early 2000s, PBMs have continually come under attack for not acting in the best interest of their clients. We have written a number of papers since 2004 pinpointing an opaque reseller business model as the source of this misalignment.
The PBM reseller business model is in stark contrast to the two other transparent business models used by managed care companies:
- a self-insurance agency model with 100% pass through of claims expenses to plans accompanied by per-member-per-month (PMPM) management fees;
- a risk-based insurance model with capitated premiums paid by plans.
The current PBM business model features five major streams of revenue and gross profits:
- “spread margins” on top of retailers own margins and lately, direct and indirect reimbursement (DIR) fees, that are collected from retail pharmacies in return for being included in preferred provider networks;
- claims processing and data fees;
- rebates given by Pharma on small molecule brand drugs in return for preferred status on formularies;
- rebates give by Pharma on speciality (biotech) drugs in return for preferred status on formularies;
- profit margins on 90-day generic Rx filled by captive mail order operations.
Since we began following PBMs in 2002, the distribution of gross profits has changed dramatically. These radical shifts in such a short period of time is unprecedented among Fortune 50 companies.
We see 3 distinct phases of the PBM business model over the past 15 years demarcated by radical shifts in the primary source of gross profits:
- up to 2005 — reliance on retained rebates from small molecule brand drugs;
- 2005 – 2010 — reliance on mail order generic Rx margins;
- 2010 – today — reliance on retained rebates from specialty drugs.
Below is a summary graph of our work on estimating the distribution of PBM gross profits by source over time. Details about its derivation and causes of shift can be found in our 2017 paper Three Phases of the Pharmacy Benefit Manager Business Model.
These radical changes are indicative of the opaqueness of the PBM business model to downstream customers — health insurance plan sponsors. It is also indicative of the power of the Big 3 PBMs to negotiate rapid changes in payment streams with upstream suppliers — retail pharmacies and brand drug companies –who tacitly collude with them to hold up prices and divide up the super-competitive profits in two intermediate market bilateral oligopolies.
PBMs As Competition-Limiting Gatekeepers to Markets
As we have summarized earlier, the PBM business model relies heavily on retaining a portion of rebates received from Pharma in return for placement on a list of drugs covered by a Rx benefit plan. That list of covered drugs is called a formulary.
The purpose of this section is to present our conceptualization of formularies as a group of markets. On the sell-side are brand drug companies with close, but not perfect substitutes, call therapeutic equivalents. On the buy-side are the Big 3 PBMs representing plan sponsors and their members.
Economists call such markets bilateral oligopolies. We have written a number of papers about the Pharma – PBM bilateral oligopoly available for download free on our website.
Rebates are essentially tariffs paid by drug companies to PBMs for access to markets with limited competition.
The formulary is a lookup table that PBMs add to their claims processing systems that checks a Rx request against a list of therapeutic equivalents preferred by the plan. The formulary is designed to limit Rx to the most cost-effective drug(s) in each of 50-80 different therapeutic classes.
In terms of pinpointing where drug companies and PBM negotiate rebates, it is important to note that there are 3 basic types of therapeutic classes or markets:
- competitive — featuring at 2+ drugs that have lost patent protection and have lower cost generics that are therapeutic equivalents to remaining brands;
- monopolistic – featuring a single first-to-market “innovative” patented drug;
- oligopolistic — featuring a small number of patented drugs that are therapeutic equivalents that becomes increasingly competitive over time as new “me too” drugs enter and older drugs lose patent protection opening the door to generics or “biosimilars”.
In the case of (1), drug companies are powerless and prices fall to marginal costs so no rebates can be paid. Also, no substantial rebates are paid in the case of (2). Here the monopolist drug company is all powerful knowing that they must be included. It is only in case (3), the bilateral oligopoly, that prices are negotiated among the few.
Our assessment of where rebates are paid was confirmed by a 2005 FTC study of PBM operations. It confirmed that Pharma pays rebates only on a small portion of brand drugs. It does not pay on brand drugs with a monopoly position. Nor does Pharma pay on brand drugs in aging therapeutic classes where most of the competing brands have lost patent protection.
The FTC study also confirmed that Pharma negotiates brand rebate deals only with PBMs, and not retail drugstore chains like Walgreen and CVS. Size does not matter on the buy-side if an entity does not also have the power to affect the demand for brand drugs through discretion in formulary design and compliance.
On the other hand, it is generic drug manufacturers that negotiate volume discount deals with drugstores because only dispensing pharmacies have the power to choose from an array of suppliers of perfect substitutes.
Again, no rebates would be paid even in case (3) if there were many PBMs competing for business. PBMs would be price takers in this case as any attempt to extract a lower price from a drug company and the drug company would walk away from the deal with little loss in business.
Finally, there would be no concerns about PBMs resorting to misaligned formularies and opaque rebate retentions if they would have adopted a transparent fee-for-service and 100% pass through business model.
In other words, PBMs as countervailing powers, a term coined by economist J.K. Galbreath in the 1950s, have the potential to enhance consumer welfare. But, countervailing powers with a misaligned business models won’t. See our 2007 paper PBMs As Conflicted Countervailing Powers.
The Connection Between Formulary Design and Rebates
We conclude this paper with an observation that PBMs have changed their approach to formulary design over the past 15 years. We are just beginning to figure out the causes of this change.
But the basic idea, appearing first in our 2005 paper on PBMs as bargaining agents, is this:
The more a gatekeeper limits competition, the more potential entrants will pay for access. Small molecule therapeutic classes tend to be open, hence less valuable to entrants. Specialty and biotech therapeutic classes tend to be closed, hence more valuable to the single favored entrant.
Today, PBMs need to squeeze everything they can from access to specialty therapeutic classes because there are lot fewer of those classes than the small molecule drug therapeutic classes that they relied on before 2010.
A recent paper of ours presents in more detail how PBMs coax Pharma into having high list prices so that they can take back most of the inflated list price via opaque deep discount rebate rates.
Today PBMs struggle with a rebate “basis” that is a lot less than it was ten years ago. How much less? A study sponsored by the Pew Foundation found that in 2015 specialty Rx comprised only 1% of total Rx.
A decade ago, we estimated that about 20% of total Rx filled were “rebatable” brand drugs, i.e. in formulary classes with a few other brand drugs that were therapeutic equivalents. So instead of 1:100 specialty Rx to total Rx basis differential, we arrive a 1:20 “rebatable” specialty drug Rx to “rebatable” small molecule brand drug Rx basis differential.
In other words, ten years ago PBMs has 20 times the volume of Rx available to them to use as a basis for generating retained rebates as they do today.
It is the greatly reduced basis for generating retained rebates today that is root cause of formulary designs with closed therapeutic classes. The greatly reduced rebate basis is also a factor in such new phenomena as the gross-to-net drug price bubble, and a growing lists of drugs outright excluded from formularies.